How do you value an early stage business?
In this article, we cover some methods to value a business to raise venture capital. These are used for tech businesses (e.g. fintechs and cleantechs), but could also be used for non-tech ones.
Venture Capital Method
Venture capital firms are a primary source of funding for businesses in the early stages looking to raise £100,000 or more. Many if not most VCs use the Venture Capital Method (VCM) – or a variation of it – to value the businesses they invest in. Professor Bill Sahlman of Harvard Business School originally described it in a 1987 case study (revised in 2009).
This is a method for valuing high-risk, long-term investments, which uses the following equations:
Return on investment (ROI) = terminal value/post-money valuation
Post-money valuation = terminal value/anticipated ROI
- Terminal value is the start-up’s anticipated selling price in the future.
- Anticipated ROI is the 10+X return the investor expects.
A fintech start-up example
A VC firm, based on similar start-up exits (transactions where investors sell shares in businesses), expects the terminal value of an automated trading platform to be £10 million and looks for a 10X return. It calculates the post-money valuation of the start-up as follows:
10,000,000 / 10 = £1,000,000
The founders need £200,000 to obtain a positive cashflow. That means that they need to offer 20% of the company to external investors. The pre-money valuation of the start-up (the business value not including the external investors) is:
1,000,000 – 200,000 = £800,000
The VCM is simple and straightforward. However, assessing the riskiness of a start-up requires assumptions which can produce wildly varying results. Use it in conjunction with one or two other methods (e.g. the ones below) to arrive at a more comprehensive valuation.
The valuation could include sensitivity analysis, dilution, multiple rounds, and scenarios (base, best and worse).
Dave Berkus, an angel investor and venture capitalist from California, created a basic but popular method to value a start-up. It is based on the idea that the best way to value a start-up is to use risk-reduction elements (rather than projected financials). Berkus is for start-ups that have the potential to achieve gross revenues of at least US$20m at the end of the fifth year in business. It values a start-up using five risk-reduction elements: sound idea, prototype, management team, strategic relations, and product rollout/sales. Each element can add up to US$500,000.
Also known as the Bill Payne valuation method, it compares the target start-up to recently funded businesses to establish the valuation of the target. It uses the following factors to assess the target: management team, opportunity size, product/technology, competition, marketing/sales/partnerships, additional investment need, and other. Each factor is: rated (e.g. team is strong = 125% of norm); multiplied against the factor range (weighting); and summed up to give the total factor, which is then multiplied against the average industry valuation.
Later stage methods
There are many more valuation methods to value businesses, especially for later stage ones, such as First Chicago and Discounted Cash Flow. But they may be too complex and inappropriate for earlier stage businesses. For more on valuation, see the International Private Equity and Venture Capital Valuation (IPEV) Guidelines, which represent current best practice, on the valuation of private capital investments.
Environmental, Social, and Governance (ESG) factors should also be included in the final valuation. This is not a standard practice (yet), but it should. We will cover it in a future blog article.
One caveat to keep in mind: all methods to value a business to raise venture capital are more art than science!
To learn how we can help you value your start-up and assess what sort of business finance options are available for your specific stage and culture: